Federal Reserve’s inflated (and risky) balance sheet – analysis – Eurasia Review

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By Bill Bergman *

The Fed has embarked on a massive expansionist quest in recent years. In 2020, the Reserve Bank’s total assets grew from $ 4.2 trillion to $ 7.4 trillion amid the pandemic and related government foreclosure and fiscal “stimulus” policies. This was about three times the extraordinary growth in the consolidated balance sheet of reserve banks during the 2008-2009 financial crisis. And in the latest weekly “H.4.1” release, total assets reached $ 7.8 trillion – up about $ 100 billion a month so far this year.

In banking, rapid growth is not difficult to achieve if you are willing to take risks. In fact, rapid growth should always be questioned as a possible sign of undue risk-taking. What about federal reserve banks? How many risks do they take and at what cost?

To answer these questions, we must first identify the accounting principles on which the Fed’s balance sheet is based.

In the United States, there are “generally accepted accounting principles” (GAAP) – but there are different traits for different people. Private sector companies follow accounting standards set by the FASB – the Financial Accounting Standards Board. State and local governments follow a different set of “generally accepted” rules that are set by the GASB – the Governmental Accounting Standards Board. The US federal government follows another set of “generally accepted” principles established by the FASAB – the Federal Accounting Standards Advisory Board.

Let us leave aside for now the question of whether “generally accepted accounting principles” can even exist in a world where there are more than three sets of them, including international accounting standards. Who sets the accounting standards for the Federal Reserve?

There are two main parts of the “Federal Reserve”. The Federal Reserve Board of Governors is an independent regulatory commission, a government agency, and it follows federal government standards set by the FASAB. But Federal Reserve Banks are another story: they follow accounting standards set by the Federal Reserve Board of Governors! These standards are not GAAP.

One way the Fed’s principles for reserve banks differ from GAAP questions is to understand the significant risks facing reserve banks and, therefore, the US Treasury.

Reserve bank assets include trillions of dollars in bonds, most of which are government bonds or government guaranteed. Like any bond portfolio, these investments are subject to interest rate risk. When interest rates rise, bond prices fall (and vice versa).

According to the Board of Governors’ accounting standards for reserve banks, “unrealized” losses in the value of bond investments are not immediately reflected in the financial statements. It is only when losses are “realized” (for example, when bonds are sold) that the loss is reflected in the financial statements.

Today, short- and long-term government bond interest rates are near their historic lows, which is important in part because the Fed has massively increased its purchases of government bonds. But low interest rates cannot be taken for granted, especially if we get significantly higher inflation expectations – which seem to have started to germinate in recent weeks.

If we get significantly higher interest rates for this reason, the impact on the Reserve Bank’s balance sheet of losses on securities assets would occur if the losses were to become “realized” – a realistic prospect if the Reserve Bank Federal government reversed course and began to sell securities as a means of conducting monetary policy in a context of higher inflation expectations.

This impact, and this risk, is higher for entities with significant financial leverage. And reserve banks are among the most indebted banks on the planet. On the 2020 balance sheet, which reported $ 7.4 trillion in assets, reserve banks reported “only” $ 40 billion in total capital – a capital-to-asset ratio of half a percent.

For a given percentage change in asset value, highly leveraged entities will see a larger percentage drop in capital value. In this case, reserve banks would start reporting negative capital after losses amounting to only half a percent of their total assets.

In other words, if they were required to recognize losses. According to the current standards set by the Board of Governors, they will not start doing so until the losses are realized on sales on the open market. And even then, the reserve banks won’t show a negative amount of capital because the Fed sets its own accounting standards, at least for the reserve banks, and changes them as it sees fit.

In 2011, after the first upward spike in reserve banks’ balance sheets with the financial crisis, the Federal Reserve Board of Governors changed the accounting standards for Federal Reserve banks. These changes have limited the possibility that the capital account of reserve banks will ever turn negative. And more recently, some have argued that the Fed’s control over its own accounting principles could allow even more creative ways to cushion the blow of possible investment losses.

But a free lunch for the Fed isn’t necessarily a free lunch for the rest of us.

The problem (and risk) facing the Treasury (and the rest of us) is compounded by the Fed’s new, legally dubious practice of paying interest on the reserves that banks maintain with reserve banks. If short-term interest rates were to rise amid heightened concern over inflation, under current policy the Fed would pay higher interest on huge reserve balances worth several trillions of dollars. dollars currently in reserve banks.

Presenting its own balance sheet, a balance sheet with roughly $ 6 trillion in assets versus nearly $ 33 trillion in (underestimated) liabilities, the federal government gives us the following heartwarming words:

However, the government has other important resources that go beyond the assets presented in these balance sheets. These resources include the management of real estate and businesses in addition to the sovereign powers of the government in matters of taxation and setting monetary policy.

In other words, we should be reassured that our government will be able to deprive us of our money or inflate the dollar to pay off its debts.

Perhaps we shouldn’t be comforted by these claims, especially because they come in a document that theoretically puts the responsibility of government on the real ruler of the United States – the people.

The Federal Reserve has consistently returned its profits to the Treasury for decades. And the government seems to see the Fed and monetary policy as its trump card. But it is not necessarily an asset for the people.

When justifying the Fed setting its own accounting standards, Fed executives consistently claim that the value of central bank independence justifies this state of affairs. But how independent is the Fed really under current law and policy?

In 2010, the Government Accountability Office’s (GAO) opinion on the US government’s financial statements began to include a caveat about the risks of the Fed’s swelling balance sheet for the Treasury. GAO Opinion Letters ceased to include these notes in 2015. Now that the Fed’s balance sheet is booming again, these issues deserve closer examination.

* About the Author: Bill Bergman is the Research Director for Truth in Accounting, a nonprofit public finance watchdog, and a finance instructor at Loyola University in Chicago.

Source: This article was published by the MISES Institute


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